Why Yahoo! (YHOO) Will Never Recover

Yahoo! (YHOO) will never recover from its botched negotiations with Microsoft (MSFT), in which the larger company offered to buy it in early 2008. The initial offer was for $44.6 billion, or $31 a share. Yahoo! turned the deal down and by November of last year, its stock traded below $9.

Yahoo!’s new CEO, Carol Bartz, has made a series of mistakes early in her tenure, and the company probably cannot recover from them either.

Yahoo!’s current dilemma, from a financial standpoint, is that it is not growing and operates on razor thin margins. In the first quarter, the firm made only$121 million on $1.82 billion in revenue. The company has no significant margin to keep its earnings positive if revenue drops. Bartz’s initial answer to this was to let people go. Yahoo! fired 1,500 staff members beginning late last year, to save $400 million annually. That may only be the beginning of employee reductions if sales remain weak.

Yahoo! has not developed any effective strategy to have any presence in the fast-growing social network sector. The same can be said of Microsoft (MSFT) and Google (GOOG). Each company may regret its lack of success in entering the the online world created by MySpace (NWS), Facebook, and Twitter. Because of its size in relationship to Microsoft and Google, Yahoo! can least afford to let major opportunities pass. It is still questionable whether social networks will make money, but Facebook is growing so fast that it may ultimately have more unique visitors than Yahoo!. A large social network relationship would allow the No.2 search company to extend the presence of its technology and its opportunity to make money by getting tens of millions of new users. Yahoo! only has $3.5 billion in cash and short term securities. That is not nearly enough to buy a large social network. Facebook was recently valued at $10 billion which is about half of Yahoo!’s market capitalization.

Yahoo! has not shown that it has an aggressive strategy to move into the mobile search market, a place where it has to be successful to extend its reach beyond the PC. Recent data from Citigroup says that Google has 61% of the mobile search market. Microsoft has shown that it is willing to pay large sums to become the default search software on major cellular platforms. The world’s largest software company struck a deal earlier this year with Verizon Wireless (VZ)(VOD). The terms reportedly give Verizon a minimum of $550 million over five year in exchange for Microsoft being the default search program on Verizon handsets. Yahoo! does not have the cash to be a viable bidder for this kind of placement on large cellular services.

Yahoo!’s most important strategic blunder is likely to be the refusal of CEO Bartz to form a search partnership with Microsoft quickly after taking the top job. The industry has known for months that Microsoft was about to launch the next generation of its search product. Bartz and many experts believed that Microsoft did not have the product development and engineering expertise to build a highly competitive search engine. This turned out to be an underestimation of Microsoft’s resolve, its willingness to invest great sums of money on risky ventures, and the prowess of its developers.

Yahoo! now faces Microsoft’s new search product, Bing, and a pledge by Microsoft’s CEO Steve Ballmer that he is willing to invest as much as 10% of his company’s operating income over the next five years to become a power in the search industry. This investment could be $20 billion by most estimates, a sum that Yahoo! cannot come close to matching.

Bing is off to a remarkably good start. Microsoft has historically had 8% to 9% of the US search market compared to Yahoo!’s 20% and Google’s 65%. Early results show Bing’s share surging as high as 13% of 14% in the three weeks after its introduction. Some of that growth is likely to come at Yahoo!’s expense because its search product is weaker than Google’s. Google may be able to lose two or three market share points. Yahoo! cannot afford to lose any.

Bing may be able to hold its improved position. If the Microsoft product pulls users evenly from Google and Yahoo!, it would have 14% of the market compared to to Yahoo!’s 18%. The billions of dollars Microsoft is willing to spend to improve its position makes it likely that Redmond will will further shrink Yahoo!’s advantage.

Microsoft has a chance, to catch Yahoo! over the next year or so. Yahoo!’s value will plunge if this happens and Microsoft’s need to have a deal which combines the search market operations of the two companies will be significantly less. Microsoft could still make an offer for a partnership with Yahoo!. Nonetheless,Yahoo! will have lost a great deal of its leverage and its shareholders will lose most of their opportunity to profit.

Bartz only had to make one important decision in her early tenure at Yahoo! and she made the wrong one.